Edited version of private advice

Authorisation Number: 1052264523546

Date of advice: 9 July 2024

Ruling

Subject: CGT - lump sum insurance payment

Question 1

Is the insurance payout amount for loss of rental income included in your assessable income?

Answer

Yes. The amount you received that compensates you for the loss of rental income is ordinary income.

Question 2

Is the ex gratia payment you received included in your assessable income?

Answer

Yes.

Question 3

Is the building policy payment you received to cover repairs to the property included in your assessable income?

Answer

No. The building policy payment amount is considered a recoupment and is not assessable for income tax purposes.

Question 4

Can you claim deductions for the ongoing repairs to the property?

Answer

No. While the property is not used in the production of assessable income in the year of income in which the expenditure is incurred, you cannot claim deductions for ongoing repairs. However, any expenditure may form part of the cost base of the property for Capital Gains Tax (CGT) purposes.

Question 5

Did a CGT event occur when you received the insurance payout amounts?

Answer

No. Any capital gain or capital loss will arise on disposal of the property.

Question 6

Does the building policy payment (the recoupment amount) reduce the cost base of the property for CGT purposes?

Answer

Yes. The building policy payment is a recoupment amount will reduce the cost base of the underlying asset.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

In 20XX, you purchased a property (the Property), which became your main residence.

Between XX XX 20XX and XX XX 20XX, the Property was an investment property.

In XX 20XX, the Property was affected by a natural disaster (storms), the damage was incurred when the property was tenanted.

The Property was impacted by mould and water damage.

You lodged an insurance claim with the Insurer, with the intention to rectify mould and minor repairs.

You relied on the Property Manager to manage the repairs.

Between XX 20XX and XX 20XX, you entered into protracted negotiations with the Insurer.

The tenants became increasingly agitated whilst you were engaging with the Insurer, requesting action to clean up the mould.

On XX XX 20XX, the lease with the existing tenants expired. The Insurer advised the Property was required to be vacated to attend to the mould in the Property.

The contractor removed the following from the downstairs section of your Property:

•         Walls

•         Ceilings

•         Doors

•         Kitchenette

•         Bathroom floor tiles

•         Bathroom vanity

•         Toilet; and

•         Disconnected electricals.

The contractor removed the following from the upstairs section of your Property:

•         Entire ceiling

•         Carpets

•         Selected blinds

•         Some kitchen cupboards

•         Light fittings

•         All electricals were disconnected; and

•         Smoke alarm system.

The Property was left uninhabitable with no power.

Between XX XX 20XX and XX XX 20XX, the contractor had control of the Property.

In XX 20XX, the Insurer offered a cash payout and advised they would not be engaging a builder to complete the work to repair the damage from the demolition of the Property.

Given discussions regarding the insurance claim were still ongoing, you escalated your matter to the Australian Financial Claims Authority (AFCA).

Until XX XX 20XX, the Property remained vacant.

Effective XX XX 20XX, the Property became your main residence as you were not able to rent out due to being in a state of disrepair.

On XX XX 20XX, the Insurer wrote to you and advised they would offer a cash payment for full settlement of the home insurance claim, in lieu of repairing or replacing the loss or damage.

You accepted the cash offer from the Insurer.

On XX and XX XX 20XX, you received 3 cash payments as follows:

•         ex gratia payment

•         payment for loss of rental income; and

•         building policy payment for the trades quote.

You are using the insurance payment to engage trades to complete repairs.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 section 116-20(1)

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 Section 102-20

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that assessable income of Australian residents includes ordinary income derived directly or indirectly from all sources.

Ordinary income includes income from rendering personal services, income from property and income from carrying on a business. Section 6-5 of the ITAA 1997 states that income according to ordinary concepts (ordinary income) is assessable income.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are statutory income and are also included in assessable income. Net capital gains are included as assessable income under subsection 102-5(1) of the ITAA 1997.

Amounts received as a lump sum are generally capital in nature and are potentially taxable as statutory income under the CGT provisions of the ITAA 1997.

Part 3-1 of the ITAA 1997 contains the capital gains and capital loss provisions. You make a capital gain or capital loss if a CGT event happens in respect of a CGT asset.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipt discusses the ATO view regarding compensation payments, including the tax treatment of compensation receipts for permanent damage to, or permanent reduction in the value of an underlying asset.

Paragraph 3 defines the term 'permanent damage or reduction in the value' as not meaning an everlasting damage or reduced value, but damage or value reduction which will have permanent effect unless some action is taken by the taxpayer to put it right.

Loss of rental income

For income tax purpose, an amount paid to compensate for loss generally acquires the character for that which it is substituted.

A payment or benefit received by a taxpayer is included in your assessable income if it is:

•         Income in the ordinary sense of the word, being ordinary income, or

•         An amount or benefit that through the operation of the provisions of the tax law is included in assessable income, being statutory income.

The determination of the character of a payment and whether it is liable to tax, depends on the nature of the payment. A compensation payment to make up for lost earnings or in substitution for income which would otherwise have been earned is in the nature of income and is liable to income tax.

The lump sum amount you received for the loss of rental income is income according to ordinary concepts and is therefore assessable income pursuant to section 6-5 of the ITAA 1997.

Ex gratia payment

Under section 104-25 of the ITAA 1997 a CGT event C2 happens when your ownership interest of an intangible CGT asset ends.

Paragraph 11 of TR 95/35 states that if a taxpayer receives a compensation amount that relates to the disposal of the taxpayers right to seek compensation, then CGT event C2 will occur.

Paragraph 70 of the TR 95/35 discusses the capital gains tax implications for compensation receipts. It provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt.

The 'look-through' approach is the process of identifying the most relevant asset. It requires an analysis of all possible assets of the taxpayer to determine the asset to which the compensation amount is most directly related. It is also referred to as the underlying asset approach.

You have entered into an agreement to accept a lump sum ex gratia payment to resolve your dispute with the Insurer. Thus, the relevant asset is the right to seek compensation. It is considered the ex gratia lump sum amount you received is a payment for the ending of the right to seek compensation. Your right to seek compensation, was disposed of when you entered into the agreement with the Insurer. Therefore, CGT event C2 happened, the capital gain from this ex gratia payment forms part of your taxable income.

Building policy payment

Subsection 20-25(1) of the ITAA 1997 states that recoupment of a loss or outgoing includes:

a)    any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described; and

b)    a grant in respect of the loss or outgoing.

The building policy payment you received is a recoupment amount and is regarded as a capital receipt. In your case, the portion of the insurance payment your received that is considered a recoupment is not a substitute for loss of income and is not assessable under section 6-5 or section 6-10 of the ITAA 1997.

A payment in these circumstances reduces the cost base of the underlying asset, which is your investment property. On disposal of the property, a CGT event A1 will occur and the recoupment amount will reduce the cost base of the asset. Any expenditure you incur to repair the storm damage to the property, may form part of the cost base of the property for CGT purposes.

Deductions for repairs to property carried out after cessation of income production

Section 8-1 of the ITAA 1997 provides that losses or outgoings are deductible to the extent they are incurred in the gaining or production of assessable income. Subsection 25-10(1) of the ITAA 1997 states that you can deduct expenditure you incur for repairs to premises (or part of premises) or a depreciating assets that you held or used solely for the purpose of producing assessable income.

Taxation Ruling IT 180 - Repairs to property carried out after cessation of income production explains at paragraph 4 that a deduction may be allowed for the cost of repairs to the property providing:

a)    The necessity for the repairs can be related to a period of time during which the premises have been used to produce assessable income of the taxpayer; and

b)    The premises have been used in the production of assessable income of the year of income in which the expenditure is incurred.

If both conditions are not met, a deduction may not be allowable for any expenses incurred. However, the expenditure may form part of the cost base of the property for CGT purposes.

Taxation Ruling TR 97/23 Income tax: deductions for repairs provides at paragraph 79 that expenditure for repairs to property used only partly for income producing purposes during a year of income, and partly for non-income producing purposes, are only deductible to the extent that that it is reasonable under the circumstances.

We would expect that the amount of expenditure allowable as a deduction under subsection 25-10(2) of the ITAA 1997 would ordinarily be calculated by reference to the extent to which the property was held in the year of income for income producing purposes.

Recoupment and application to cost base of an underlying asset for CGT purposes

Section 116-20 of the ITAA 1997, provides the general rules about capital proceeds from a CGT event. Section 104-10 of the ITAA 1997 states that CGT event A1 happens if you dispose of a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

Paragraph 6 of TR 95/35 explains that if an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset. A post-CGT asset is one that the taxpayer as acquired after 20 September 1985.

Paragraphs 7 and 8 of TR 95/35 provide that the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation. No capital gain or capital loss arises in respect of the asset until the taxpayer actually disposes of the underlying asset. Therefore, there is no capital gain or loss at the time of receipt of the recoupment amount.

Application to your circumstances

The insurance payment you received for the loss of rental income is assessable income pursuant to section 6-5 of the ITAA 1997.

The ex gratia payment you received is an ending to your right to seek compensation and is assessable under section 6-10 of the ITAA 1997. CGT event C2 happens when your ownership interest of an intangible CGT asset ends.

The building policy payment portion of the lump sum payment is for repairs and replacement, compensating you for permanent damage to the investment property. The compensation payment in these circumstances is considered a recoupment amount which directly reduces the cost base of the underlying asset.

As the recoupment amount is not considered assessable income, it follows that any expenses you incur in remedying damage or defects will not be deductible given the property is no longer being used to produce assessable income.

When you dispose of your investment property, CGT event A1 will occur. The portion of the compensation payment you received that is considered a recoupment will reduce the cost base of the underlying asset. The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred.

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